If you’re considering a private placement utilizing the Delaware Statutory Trust (DST) structure, chances are that program is utilizing a Master Lease. To understand why let’s first take a quick look at the DST structure.
The DST Structure was developed to provide real estate investors with an investment vehicle through which they could acquire an interest in commercial real estate that would be treated as qualifying replacement property for purposes of the like-kind exchange rules of Section 1031 of the Internal Revenue Code (the “Code”). Under the like-kind exchange rules of Code Section 1031, an interest in real estate that is held through a multi-member limited liability company or through another structure that is treated as a partnership for federal income tax purposes cannot be treated as qualifying replacement property under the Code.
The DST Structure addresses this qualifying replacement property issue by allowing multiple investors to acquire interests through an investment structure that, if properly designed, will not be treated as a partnership for federal income tax purposes. Under the DST Structure, the like-kind exchange investors acquire beneficial interests in a DST.
So what does all this have to do with why DSTs typically have a Master Lease? The answer to that question lies in understanding the strict limitations under which a DST may operate, otherwise known as the 7 Deadly Sins of DSTs. We won’t get into all seven sins right now but we will discuss one very important one. This particular “sin” prohibits the Trust from entering new leases or renegotiating or modifying existing leases other than to deal with a bankruptcy or tenant insolvency. Now obviously, for a property with short-term leases, like a self-storage property, this is quite a problem as leases churn regularly during the investment hold period.
Enter the Master Lease
To solve this problem, the DST leases the property to a Master Tenant (via a Master Lease) who is responsible for negotiating and/or entering into new leases with the underlying clients. In addition to handling lease concerns, the Master Tenant is charged with operating and maintaining the property while the Trust remains responsible for property capital expenses such as replacement of the roof, parking lot, etc.
Master Lease Considerations
So now that we understand why we need this Master Tenant in the mix, let’s talk about major considerations when evaluating a Master Lease. In Buttonwood’s opinion, the primary factors that warrant scrutiny include: Master Tenant capitalization, rent considerations, the durability of rent payments and Master Tenant (Sponsor) projected profitability.
Master Tenant Capitalization
In the majority of private placements reviewed by Buttonwood that have a Master Lease in place, the Master Tenant is typically initially capitalized by three primary sources: i) Cash, ii) a demand note from the Sponsor, and iii) a Master Tenant reserve established from offering proceeds. One important point to remember when considering the capitalization sources is that in theory, if the property operates as projected, the Master Tenant will meet its obligations with funds from operations and will not need toutilize the capitalization sources.
Cash: While logic may suggest that you would want the Master Tenant to start with a huge pile of cash, in reality that’s not the case. Any cash that’s allocated to the Master Tenant will typically come straight from investment proceeds raised and will be retained by the Master Tenant at the end of the program. Therefore, it’s more beneficial for investors to see the bulk of the capitalization available in the demand note and Master Tenant reserve.
Demand Note: There are two primary considerations to evaluate here. First, how much is available via the note? Buttonwood would love to see funds available via the demand note to cover at least one year (or more) of Base Rent payments (more on Base Rent later) but the reality is that in most DST programs that we review, this demand note is typically only adequate to cover roughly 2 - 4 months of base rent payments to the Trust. Second, the value of this demand note is based entirely on the financial strength of the sponsor entity. If the sponsor is shaky from a financial perspective, the demand note may not be worth much more than the paper it is hypothetically printed on. (For help in evaluating the financial strength of a particular sponsor, request or download Buttonwood’s applicable sponsor report on that entity)
Master Tenant Reserve: Surprisingly enough, not all programs with a Master Lease establish a Master Tenant reserve, instead opting to increase the amount available via the demand note or going on faith that operations will produce adequate cash flow. In Buttonwood’s opinion, this is a considerable problem as a reserve represents funds sitting in an account available for use while the demand note may not be available if the sponsor struggles financially. Plus, an additional factor in favor of the establishment of a reserve is that most Master Tenant leases provide for the return of any unused portion to investors at the end of the program.
When evaluating the rent payable under a Master Lease structure it’s important to understand the various obligations of the Master Tenant. The Master Tenant will receive the gross amount of revenues from rent collections and other income associated with operating the property. From this gross amount, the Master Tenant is required to pay any property debt payments and property operating expenses, leaving operating cash flow which it will use to pay the lease payment to the Trust typically in the form of Base Rent and Bonus or Percentage Rent.
- Base Rent: When evaluating the level of Base Rent payments, it’s important to understand the balance that must be struck. Too high of a Base Rent payment and the Master Tenant may struggle financially and risk defaulting on the payments which will cause significant headaches for all parties involved, including potential loss of 1031 tax treatment. Too low of a payment and the Master Tenant will capture and retain too large a portion of the property’s profitability, reducing investor return. Buttonwood likes to see a Base Rent payment set at a level where the Master Tenant roughly breaks even or even experiences a loss in year one of the lease. If the property is being operated efficiently, that break-even level will turn into profitability for the Master Tenant – which is a good thing. Remember, the Master Tenant needs to have a reasonable expectation of long-term profitability to incentivize the Sponsor to step into that Master Tenant role. Once that Base Rent level is set, it needs to grow. In the programs we review at Buttonwood, we typically see annual Base Rent escalations of 1.5% - 3.5% annually. Ideally a program will have a rent growth rate of at least 3.0% to keep pace with historical inflation rates. Lastly, when considering Base Rent, do not forget about lease extensions. Most Master Leases have extensions that allow the Master Tenant to extend the lease for an additional 10-15 years beyond the base term. These lease extensions should offer rent escalation rates at least on par with the base term rent escalation rates.
- Bonus or Percentage Rent. Bonus Rent, or Percentage Rent, is additional rent paid to help investors capture a portion of the profitability above Base Rent payments. Bonus Rent typically comes into play 2-3 years into a lease term after the Master Tenant has had a year or two to stabilize property operations. Bonus Rent is typically calculated as a percentage of the difference between the gross rent received by the Master Tenant and a baseline amount. For example, let’s say the baseline amount is set at $1,000,000 and the Master Tenant recognizes gross revenue of $1,100,000. If the Master Lease calls for a Bonus Rent factor of 90%, the Trust will be paid an additional $90,000 (($1,100,000 - $1,000,000) x 90% = $90,000). Buttonwood typically sees the Bonus Rent factor set at 75%-90% of the delta between gross revenue and the baseline amount. When assessing Bonus Rent it’s important to evaluate the appropriateness of the baseline level. If baseline amounts are set too high, the Trust will never receive Bonus Rent. Unfortunately, through the years Buttonwood has reviewed some programs where the baseline amount was set so high the property would need to double or triple income to ever have a chance of breaking past the baseline amount, so the baseline amount is a factor worth looking at and evaluating for reasonability.
Now that we’ve discussed the Master Tenant’s capitalization and the rent that may be paid under the Lease, it’s important to evaluate the durability of those rent payments and the payment flexibility that may be afforded to the Master Tenant.
- Durability: So we have cash, demand notes, reserves, debt, operating expenses, base rent, bonus rent, growth rates, baseline amounts and on and on. It’s all just a bunch of numbers floating around that potentially muddy the waters, but at the end of the day, what really matters is that the Base Rent payment is made consistently and on time. When evaluating the durability of the Base Rent payment, Buttonwood factors in the various obligations of the Master Tenant and then stress tests the Sponsor’s assumptions by cutting revenue levels in an effort to stress the capitalization at the Master Tenant’s disposal. The point of this exercise is to figure out when the money runs out. In Buttonwood’s opinion, a Master Tenant should be able to withstand a 10% drop in projected annual revenue and still make the Base Rent payment for the base lease term. Yes, in a 10% down scenario, the Master Tenant will likely exhaust some (or all) of the cash, demand note and reserves at its disposal, but investors will get their base rent payments. If a Master Tenant is unable to maintain rent payments if revenues fall short of projected performance for more than a few years, that’s a significant problem that should factor into the investment decision.
- Payment Flexibility: It’s commonplace to see language in the Master Lease allowing the Master Tenant to defer some (or all) of the Base Rent payment for a certain amount of time. This is not necessarily a bad thing as property and operating surprises sometimes necessitate a pause in payments while the Master Tenant resolves issues. What is important though are the factors governing any such pause. At the very least, any deferred payments should accrue interest at a respectable rate (at least 3%) and the lease should require that any deferred payments be made prior to the Master Tenant distributing cash to itself or any affiliates.
Master Tenant Profitability
As previously mentioned, the Master Tenant needs to have a reasonable expectation of long-term profitability to incentivize the Sponsor to step into that Master Tenant role. Profitability also potentially adds an additional layer of capitalization to the Master Tenant that may be used to cover operating shortfalls (it should be noted that the Master Tenant is typically not obligated to retain income to cover future obligations). However, while Master Tenant profit should be welcomed, too much profit is a bad thing for investors. Buttonwood likes to see Master Tenant profit at roughly 10% of all revenues collected over the lease term. This level provides respectable income for the Master Tenant and a buffer for expense fluctuations while also not being egregiously high.
Is Having a Master Lease a Positive or Negative
Buttonwood has heard both sides of the argument for and against the Master Lease and the reality is that there are valid points on both sides. On the positive side, a Master Tenant takes on the responsibility of operating and maintaining the property, stabilizes rent payments and ideally makes a consistent payment to the Trust (and investors) despite potential revenue fluctuations at the property level. On the negative side, the Master Tenant adds an additional layer of expense that often siphons off approximately 5%-15% of the total gross property revenues. Buttonwood has found that on average, the existence of a Master Lease depresses investor IRR for the life of the program by approximately 50-100 bps. However, for the reasons discussed at the start, if you have a DST structure with leases that may turn over during the hold period, you’ll need a Master Lease, thereby rendering the positive/negative discussion somewhat moot.